Chapter 9 – Agency Conflicts and Corporate Governance
Chapter Nine
Agency Conflicts and Corporate Governance
OVERVIEW
Chapter 9 describes how behavioral phenomena impede good corporate
governance. In practice, compensation systems that are intended to align the interests of
managers with those of shareholders feature insufficient variability in respect to pay for
performance, insufficient dismissal, and overpayment of executives. Overconfidence
on the part of both directors and managers interferes with the institution of appropriate
LEARNING OBJECTIVES
The main objective is for students to demonstrate that they can identify key
psychological phenomena that serve to obstruct good corporate governance. After
completing this chapter students will be able to:
Chapter 9 – Agency Conflicts and Corporate Governance
use of stock options has increased over time. Although options appear to have been
beneficial in respect to retention (the participation constraint), there is little evidence that
From the Mouths of Directors
Overconfident directors delude themselves into believing they are doing a good
job of overseeing managers. Overconfident managers render it difficult for directors to
Stock Option-Based Compensation
According to prospect theory, people are prone to overweight the small
probabilities associated with large gains. This phenomenon has been called a casino
Chapter 9 – Agency Conflicts and Corporate Governance
Auditing: Agency Conflicts and Prospect Theory
Investors rely on auditors to attest to the accuracy of firms’ financial statements.
Investors perceive auditors as agents acting on their behalf. Conflicts of interest arise
between auditors and investors when auditors’ interests involve providing clean opinions
for financial statements that they know to be problematic.
The accounting firm most closely identified with conflicts of interest was Arthur
Andersen. The accountants within Arthur Andersen witnessed a decline in their incomes
as a result of the departure of the consulting division Andersen Consulting. In response,
Sarbanes-Oxley
The Sarbanes-Oxley act was passed in response to a succession of accounting
frauds. Among other provisions, the law requires that CEOs and CFOs certify under oath
the veracity of their firm’s financial statements.
Chapter 9 – Agency Conflicts and Corporate Governance
Fraud and Stock Options: Illustrative Example
Evidence suggests that stock options appear to exacerbate the tendency of
managers to engage in fraud in respect to their financial statements. HealthSouth was the
first firm charged with fraud under Sarbanes-Oxley. Managers were charged with
preparing false financial statements to manipulate the firm’s stock price so that they
TEACHING TIPS FOR POWERPOINT SLIDES
Before showing the first PowerPoint slide, instructors might use the example of
The Producers to explain three main concepts associated with contracts designed to
Slides 3-11
Slides 3-11 discuss corporate compensation in the context of the standard
incentive framework. These slides make three points. The first point is that executive
Chapter 9 – Agency Conflicts and Corporate Governance
compensation typically satisfies the participation constraint, but violates the other two
constraints. In this respect, executive compensation typically displays:
Slide 17
Slide 17 pertains to two of three behavioral phenomena associated with employee
stock options. First, excessive optimism leads employees to increase their investment in
Slide 25
Slide 25 describes a potential agency conflict involving the relationship between
auditors and the managers of the firms they audit, namely that auditors can potentially be
Chapter 9 – Agency Conflicts and Corporate Governance
Slide 29
Slide 7 introduces the situation at the former accounting firm Arthur Andersen.
This situation is described in the Behavioral Pitfalls box about Arthur Andersen on page
211. The key point to emphasize is that accountants lost income after the firm shifted its
profit sharing rule.
The issue deals with whether there are any behavioral implications because
Arthur Andersen accountants’ income fell behind the incomes of other professionals. At
issue is whether Arthur Andersen accountants might have set their reference points so as
Slide 30
Slide 30 pertains to a series of accounting scandals at firms that were clients of
Arthur Andersen. These scandals all involved fraudulent accounting. Instructors might
Chapter 9 – Agency Conflicts and Corporate Governance
engaged in auditing, in order not to jeopardize lucrative non-audit fees that were twice as
large as the audit fees.
Slides 30-32
Slides 30-32 describe Sarbanes-Oxley, the government response to the string of
scandals mentioned in the Behavioral Pitfalls box about Arthur Andersen on page 211.
Slide 35
Slide 35 discusses the example of HealthSouth, the first firm charged under
Sarbanes-Oxley. This slide involves the last of the main issues about stock option
compensation, that stock options create an additional incentive for managers to
manipulate financial statements for the purpose of exercising stock options at favorable
Chapter 9 – Agency Conflicts and Corporate Governance
Slide 42
Slide 42 makes the point that. HealthSouth’s CEO, Richard Scrushy, was
acquitted on all charges. The acquittal represented a blow to government prosecutors who
Slide 43
The heart of the material on student cheating can be found in Concept Preview
Question 9-3. Students are typically uncomfortable about being polled on their responses
Instructors might ask students about their opinion of the actions of Andrew
Fastow, former CFO of Enron. At issue is whether Fastow’s ambition might have
Chapter 9 – Agency Conflicts and Corporate Governance
risk seeking in respect to his choice of actions? Is there a parallel with student cheating?
Are there issues of dual personalities and self-deception?
Students have a natural desire to want to separate actions that are ethical and fair
from those which are unethical and unfair. In many cases, there is wide disagreement
Additional Resources for Chapter 9 Available on the Web
On the web at www.mhhe.com/shefrin, instructors will find additional resources
that relate to Chapter 9. This material is intended for instructors who wish to delve into
Answer Key for Minicase Tyco
Case Analysis Question
Contrast events at Tyco with the events at HealthSouth described in the chapter. In what
ways were the events similar and in what ways were they different?
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